Binary Options: a Flash Primer
A binary option is simply a way to speculate if the price of an asset is going to go up or down in the future. For example, if you believe the price of a share of the German automaker BMW is going up, you could buy a binary option for EUR 10 that will pay you back EUR 17 if you are right, yielding a 70% return. If you are wrong, you will lose your EUR 10.
Although there are several types of binary options, the core idea behind all of them is the same: choose an asset, pick a time horizon, and guess what will happen to the price of the asset during that period. If your estimate is correct, you will earn a considerable return—more often than not, north of 70%. If your prediction is wrong, you will lose the price you paid for the binary option; that is, you will lose 100% of your stake. The binary option concept is really a simplified version of traditional option contracts. The word binary refers to the only two possible outcomes of buying this type of option: you will either lose all the money you have placed, or you will keep it and earn a substantial return on top of it.
Most binary options brokers offer trading in four types of assets: Stocks, Currencies, Commodities and Indices. The duration of an option contract varies depending on the underlying asset and the type of binary option. These combinations provide traders with a wide selection of time horizons to choose from. The minimum duration is usually 60 seconds and the maximum can be a few hours to a year.
The Rise/Fall Contract
This is perhaps the most common type of binary option: what will happen to the price at expiration time compared with the spot price (the current price of the asset)? If you think it will go up you buy a “Rises” contract otherwise you buy a “Falls” contract. If you buy a “Rises” contract you win if the price is higher at expiration time than it was when you placed the trade. If you buy a “Falls” contract you win if the price is lower at expiration time than it was when you placed the trade.
The Higher/Lower Contract
This is the same as a rise/fall contract, but with a slight twist: instead of using the current price of the asset as a reference, you choose a barrier or target price. Will the price at expiration be higher or lower than this barrier? Again, if you think the price will go up and be higher than the barrier, you buy a “higher” contract; otherwise, you buy a “lower” contract. If you buy a “higher” contract, you win if the price at expiration time is higher than the barrier. If you buy a “lower” contract, you win if the price at expiration time is lower than the barrier.
Placing a Higher/Lower contract on the S&P500 (snapshot from the Binary.com platform)
Picking a Winner
One way to go about placing Higher/Lower contracts is simply to follow what has worked in the past. Here are two examples:
- Placed on May 1, 2014
- Bought “Higher” contract for the “US 500 index”
- Barrier: 1884.39
- Potential return: 70%
- Stake: 2% of bankroll
- Placed on May 2, 2014
- I bought a “Lower” contract for the “Italian index.”
- Barrier: 21829
- Potential return: 80%
- Stake: 14% of bankroll